Copyright © 2004 South-Western Policy Conundrum There are no SOLUTIONS. There are just TRADE-OFFS.

Copyright © 2004 South-Western Market Failure Recall Adam Smith’s “invisible hand” leads self-interested buyers & sellers in a market to maximize the total benefit for society. But market failures can still happen! An externality arises when a person engages in an activity that influences the well-being of a bystander and yet neither pays nor receives any compensation for that effect.

Copyright © 2004 South-Western EXTERNALITIES AND MARKETS When the impact on the bystander is adverse, the externality is called a negative externality. When the impact on the bystander is beneficial, the externality is called a positive externality. Externalities cause markets to be inefficient.

Copyright © 2004 South-Western Negative Externalities Automobile exhaust Factory pollution Cigarette smoking Barking dogs (loud pets) Airplanes (landing/take-off) Landfills Chicken litter Over-fishing/grazing/driving B.O.

Copyright © 2004 South-Western Coal-Fired Power Plant The owner of the plant bears the costs of the labor, land, concrete, steel, etc. used in production but does NOT pay for the clean air used. People also agree to buy electricity (electric bill). Social Cost > Private Cost Price does not reflect true cost!

Copyright © 2004 South-Western A Voluntary Exchange between a willing buyer and seller

Copyright © 2004 South-Western But….. Although the car owner has paid for the gasoline, he has NOT paid for the clean air used as he drives. Price does not reflect true cost! COSTS that spill over onto people who don’t receive the benefits.

Copyright © 2004 South-Western Property Rights The incentives are not correct! Auto/factory pollution could be solved….. tailpipe smokestack

Copyright © 2004 South-Western Positive Externalities Immunizations Landscaping/Home Maintenance Research & Development Education Green space Rainforests Species

Copyright © 2004 South-Western Equilibrium = Balance MB = MC = P* Qs = Qd Allocative efficiency

Copyright © 2004 South-Western EXTERNALITIES AND MARKET INEFFICIENCY Negative externalities lead markets to produce and consume a quantity greater than the socially optimal quantity. Positive externalities lead markets to produce and consume a quantity less than the socially optimal quantity.

Copyright © 2004 South-Western The Market for Aluminum The quantity produced & consumed at the market equilibrium is efficient in the sense that it maximizes the benefits to market participants (buyers & sellers). If the aluminum factories emit pollution then the cost to society of producing aluminum is larger than the cost to aluminum producers. For each unit of aluminum produced, the social cost includes the private costs of the producers plus the damage to those bystanders adversely affected by the pollution.

Figure 2 Pollution and the Social Optimum Copyright © 2004 South-Western Equilibrium Quantity of Aluminum 0 Price of Aluminum Demand (private value) Supply (private cost) Social cost Q OPTIMUM Optimum Cost of pollution Q MARKET

Copyright © 2004 South-Western Negative Production Externality social cost > private cost The intersection of the demand curve and the social-cost curve determines the optimal output level. The private market outcome over-produces and consumes aluminum at the market equilibrium quantity.

Copyright © 2004 South-Western The Market for Education When an externality benefits the bystanders, a positive externality exists…..the social value of the good exceeds the private value. Education can be considered a positive externality Educated children are more likely to become good citizens (voters, productive workers, less crime). Benefits spill over to general public beyond the benefit to individual students.

Figure 3 Education and the Social Optimum Copyright © 2004 South-Western Quantity of Education 0 Price of Education Demand (private value) Social value Supply (private cost) Q MARKET Q OPTIMUM

Copyright © 2004 South-Western Positive Consumption Externality social benefit > private benefit The intersection of the supply curve and the social- value curve determines the optimal output level. The private market outcome under produces and consumes education at the market equilibrium quantity.

Copyright © 2004 South-Western Solving (addressing) Externalities Internalizing an externality involves altering incentives so that people take account of the external effects of their actions. The government can internalize an externality by imposing a tax/subsidy to reduce/increase the equilibrium quantity to the socially optimal level. Patents & Copyrights

Copyright © 2004 South-Western Getting an Education Provides Great Benefits (even for those not in school) Social Value > Private Value Private market will under-do it. Mandate and subsidize! What would society look like if we left all education up to the private market?

Copyright © 2004 South-Western Immunizations Reduce the Likelihood of Disease (even for people who don’t get immunized) Social Value > Private Value Private market will under-do it. Mandate and subsidize! What would society look like if we left all immunizations up to the private market?

Copyright © 2004 South-Western Taxing Activities with Negative Externalities Cigarettes Alcohol Soda/Junk Food Gasoline Carbon

Copyright © 2004 South-Western Government action is not always needed to solve the problem of externalities. The Coase Theorem proposes that if property rights are clearly defined and protected private parties can negotiate without cost, then they can solve the problem of externalities on their own. Transaction costs are the costs that parties incur in the process of agreeing to and following through on a negotiated settlement.

The Citrus Farmer & The Fisherman

Copyright © 2004 South-Western The Coase Theorem $2,000$100 $300$600 citrus farmer fisherman profits per week high output low output

Copyright © 2004 South-Western The Coase Theorem $2,000$1,000 $300$6,000 citrus farmer fisherman profits per week high output low output

Copyright © 2004 South-Western PUBLIC POLICY TOWARD EXTERNALITIES When externalities are significant and private solutions are not found, government may attempt to solve the problem through... command-and-control policies. market based policies (taxes, pollution permits)

Copyright © 2004 South-Western More Examples Chickens and chicken litter Burning or hauling leaves/brush and debris Airport runways Over-fishing, over-grazing Microwave ovens Green space (woods, parks) The Brazilian Rainforest

Copyright © 2004 South-Western PUBLIC POLICY TOWARD EXTERNALITIES Policy Conundrum There are no SOLUTIONS. There are just TRADE-OFFS.